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When buying a business, it’s important to know what you want.

The wrong acquisition can ruin your finances and reputation. So if you’re
unsure of how to start, I recommend researching different business types
and industries to figure out which appeals to you most.

In this blog, I’ll cover why SaaS businesses make great acquisitions,
especially for first-time buyers, and cover the things to look out for before
making your first offer.

Devising the right


methodology

Every startup is different, so you need to


choose the methodology that best fits
your business. It’s all about measuring
performance now, which is easy, and in
the future, which involves uncertainty.

All valuations start with applying a


multiple to current earnings or revenue:

Estimated value = (earnings or revenue) x multiple

So let’s explore each of these variables


in turn.

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EARNINGS

Seller Discretionary Earnings (SDE)

If you own and run a small business, apply the multiple to SDE. This is your profit after
deducting operating expenses and cost of goods from revenue but after adding back in
your compensation.

Why add in your compensation? If you’re taking the lion’s share of responsibility, you’re
taking a lion’s share of the profits as compensation and enjoying the capital and tax
advantages of being a small business owner. Adding owner compensation into SDE
therefore gives a truer measure of earnings potential.

Here’s the formula to calculate your SDE:

SDE = (Revenue - Operating Expenses - Cost of Goods) + Your Compensation

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Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)

Once you’re big enough to employ a management team, things start getting trickier. You
can’t add your compensation into earnings as you’re no longer the only one running the
show. This becomes a real cost and must be left out of the earnings calculation along with
your other expenses. Instead, apply the multiple to EBITDA.

EBITDA can be calculated in two ways, and as long as you’re consistent (not switching
back and forth to get the highest number), you can choose whichever results in a truer
representation of your startup’s earnings potential:

1 EBITDA = Operating Profit + Depreciation and Amortization

2 EBITDA = Net Profit + Interest + Taxes + Depreciation and Amortization

WHEN TO USE REVENUE

If your EBITDA or SDE is zero because you’re


investing heavily in growth, consider applying
the multiple to revenue. It’s pretty common for
SaaS businesses to accept short-term losses
in return for growth. You might focus on product
development and marketing right now, but pull
back on these expenses when you scale.

But before choosing revenue, remember you need


to prove you’re capable of such growth. Fail to do
so and your valuation collapses. Reinforce it with
projections, market research, and other evidence
to back up your number.

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Deciding the
multiple

You can derive SDE, EBITDA, and


revenue from a balance sheet in
minutes. The multiple, however, is a lot
more complicated. Where earnings is a
verifiable number, the multiple takes into
account myriad business, market, and
performance factors.

I could write a book on these, so I won’t


go into them now. Instead, I’ll focus on the
key things you need to determine where
your startup fits within a multiple range.

Between Q4 2014 and Q4 2018, Crunchbase reported a median multiple ranging from
4.43x to 9.32x with an average of 6.69x. This was for public SaaS companies only, but it’s a
good place to start. Now, you need to establish where you fit along this spectrum. To justify
a higher multiple, your startup should:

Run by itself of with very little involvement from you,

Have been operating successfully for over a year (the longer the better), and

Demonstrate growth potential.

You might be able to tick points one and two now. To tick the third, you’ll need to review
some success metrics, including:

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Churn

Churn measures lost income through net customer losses


or downsized commitments. It’s an effective measure of
customer loyalty and the quality of the product or service on
offer, but for it to be meaningful, you should compare your
churn rate with those of the industry to assess if yours is
better. The better your churn rate (ideally it’ll be negative),
the more upwards pressure on the multiple.

Customer Acquisition Cost (CAC)

Overspending on customer acquisition impacts the value of


your business so you want to keep the CAC low. Burning cash
to win new customers is a short-lived strategy that often
leads to startups failing. Investors don’t want to throw good
money after bad, so you’ll need to demonstrate a reason for
a high CAC if you want to keep that multiple high.

Lifetime Value of Customer (LTV)

A high LTV might justify a higher CAC or other revenue


losses, and is a useful way of targeting customers who offer
the best returns. When deciding what multiple to apply to
your earnings or revenue, consider churn, CAC, and LTV in
tandem for deeper insight. They each play an important role
but combined offer a more complete view of your business’s
growth potential.

Once you’ve reviewed these metrics, you’ll have a good idea where the needle falls on that
multiple range.

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Bringing it all
together

Let’s review what you’ve read so far.


To correctly estimate the value of your
startup, you need to do the following:

#1 Decide which methodology is


most appropriate.

SDE, EBITDA, or Revenue. If you own and run a small business,


SDE will suit in 99% of cases. Choose EBITDA if you’re larger
and share operational responsibilities with others, or revenue
if you’re projecting massive growth.

#2 Determine an evidence-based
multiple.

Use Crunchbase or other startup reports to establish


a range of multiples for similar businesses to your own.
Then decide where your startup fits using success
metrics like churn, CAC, and LTV (reviewed in tandem)
alongside age and operational demand.

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#3 Apply the multiple to your
earnings or revenue.

This gives you an approximate value with which you


can start conversations with buyers. Explain how you
derived the multiple so buyers trust the figure. They
might challenge your methodology, but since you’ve
done your homework, you’ll be able to defend it.

The more data you have, the better your valuations can be. Don’t gloss over things that
might impact the health of your business and you’ll have confidence in the final figure. You
might even find the professional opinion matches yours.

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